Question

Howlett Industries has annual credit sales of $120 million on terms of net 30. Current expenses for the collection department are running at 2.1 percent of sales, bad debt losses are 1.5 percent of sales, and the DSO is 38 days. Howlett is considering extending the credit period to 45 days. The change is expected to increase bad debt losses to 1.7 percent, increase the DSO to 51 days, and increase collection expenses to 2.3 percent of sales. Sales would increase to $137 million per year. Howlett’s variable cost ratio is 45 percent, its interest rate is 6 percent, and its marginal tax rate is 34 percent. Assume 365 days per year.

a. Use the income statement approach to find the incremental bad debt losses
b. Use the income statement approach to find the incremental cost of carrying receivables
c. Use the income statement approach to find the incremental pre-tax profits from this proposal
d. Use the incremental analysis equations to find the incremental bad debt losses

Answer 1

	Income statement approach
				$ In Million
	Particulars	Current	Estimated	Incremental
	a) Credit Sales	120	137	17
	b) Credit period	30 Days	45 Days	15 Days
	c) Cost of Collection Department	2.10%	2.30%	0.20%
	d) Bad Debt Losses	1.50%	1.70%	0.20%
	e) Day Sales Outstanding (DSO)	38 Days	51 Days	13 Days
	f) Variable Cost Ratio	45%	45%	0%
	g) Interest Rate	6%	6%	0%
	h) Marginal Tax Rate	34%	34%	0%
Solution (a)	Incremental Bad Debts (a*d)			0.0340	i.e. =      $	34000
Solution (b)	The incremental cost of carrying receivables
	Incremental Bad Debts (a*d)			0.0340
	The incremental cost of collection (a*c)			0.0340
	Increamental cost of interest (a*(b/365)*6%)			0.0419
	Incremental cost of carrying receivables	0.1099	i.e. =      $	109917.8
Solution (c)	Incremental pre-tax profits from this proposal
		$ In Million
	Credit Sales	17
	Variable Cost @ 45%	7.65
	Contribution	24.65
	Incremental Bad Debts (a*d)	-0.034
	The incremental cost of collection (a*c)	-0.034
	Incremental pre-tax profits from this proposal	24.582	i.e. =      $	24582000
	Note- It is assumed that interest cost is an opportunity cost of blockage of funds in a credit sale. Further, since it has an opportunity cost is has not included in the calculation in incremental pre-tax profit.
Solution (d)	Incremental analysis equations
				$ In Million
	Particulars	Current	Estimated	Incremental
	a) Credit Sales	120	137	17
	b) Credit period	30 Days	45 Days	15 Days
	c) Cost of Collection Department	2.10%	2.30%	0.20%
	d) Bad Debt Losses	1.50%	1.70%	0.20%
	e) Day Sales Outstanding (DSO)	38 Days	51 Days	13 Days
	f) Variable Cost Ratio	45%	45%	0%
	g) Interest Rate	6%	6%	0%
	h) Marginal Tax Rate	34%	34%	0%